Options Backdating: Hat's Off to Several Sell-side Research Analysts...

As a former sell-side research analyst I'm empathetic to the changing realities of that vocation. Regulation FD and the demarcation of investment banking & research (combined with the bursting of the bubble) have changed the game and, as a result, many times sell-side analysts take a fair amount of criticism (some fair, some undue).

With that in mind, I'm always on the lookout for differentiated, primary research out of the big investment banks and wanted to give a quick congratulations and tip of my hat to a group of technology analysts at Merrill Lynch and Deutsche Bank for some inspired work over the past two weeks.

Those deserving kudos...

• Merrill Lynch's Semiconductor and Capital Equipment teams (led by Joe Osha and Brett Hodess, respectively)
• Deutsche Bank's Application Software team (led by Tom Ernst)

Why they deserve kudos...

Independent of one another, both teams took it upon themselves to scan their research universes for company's that may be at risk from options backdating.

• Merrill Lynch looked at the companies comprising the Philadelphia Semiconductor Index (SOX) and analyzed the options grant dates (available in public proxies) from 1997-2002.
  • Merrill measured the equity returns for the 20 days after options issuance against the 12-month returns of the calendar year of issuance
  • Merrill found that there was a consistently stronger equity performance in the 20 days post grant versus the average returns
  • Merrill then ranked the companies in the SOX by the excess returns (and included Vitesse, a non SOX component but already under investigation for backdating as a test)
  • At the top of the list were KLA Tencor (KLAC), Marvell (MRVL), Novellus (NVLS), Linear Tech (LLTC) and Broadcom (BRCM)
    • Shortly after the report came out, KLA Tencor acknowledged the receipt of subpoenas related to past option grants
    • It should be noted that none of the other companies in Merrill's piece have announced internal or government-mandated investigations
• Deutsche Bank took an even deeper approach as it examined the broader applications and infrastructure software universe and measured their analysis over three distinct variables
  • DB looked at options grants between 1998-2002 primarily
  • 3 factors were measured
    • Performance 30 days prior/30 days post option grants (and screened for a 25% positive delta as the benchmark)
    • Frequency of outperformance following stock option grants (i.e., how many times a company's stock differential between pre- and post-grant exceeded 25%)
    • The options grant price compared to the stock's 52-week low
  • In the resultant study, DB also included non-software companies that have already publicly disclosed options investigations (as a measure of the screens predictive value)
    • Out of companies with the highest scores (i.e., at risk to backdating)...seven of the ten were under investigation (JBL, POWI, MERQ, VTSS, CMVT, BRKS, SFNT)
    • The top company in the screen? Quest Software (QSFT)...Quest came out a few days later and announced an internal investigation into its option grants

Regardless of the ultimate outcome of any individual investigations into prior options grants, it's increasingly rare to see sell-side research analysts put themselves out there like this and it deserves a nod. Remember, inviting this kind of speculation against their coverage universe isn't the easy road for these analysts. They rely, in part, on an amicable and collaborative relationship with their coverage list and putting out this research, which implicitly suggests caution to investors, doesn't engender goodwill with company management.

Note: At the time of this writing I, and/or funds I maintain discretionary control over, may maintain long equity positions in any of the companies mentioned. We did not maintain a short equity position in any stock mentioned (either explicitly in this blog post or in the underlying research reports by Merrill Lynch and Deutsche Bank).

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